The bad, the good and the ugly

DELEVERAGING, history tells us (via McKinsey research) is set to be the main economic trend for years to come. But a new paper by Anat Admati and her co-authors shows (amongst lots of other things) that the term is pretty unhelpful. The paper contains more interesting evidence on the bank capital debate, and as a part of that argument shows that deleveraging could mean either smaller balance sheets or larger ones. Here’s a diagram:

The first way to cut leverage—the ratio of assets to equity—is to reduce the amount of debt a household, firm, bank or government holds. In order to balance the books, assets must be reduced too. If you believe that assets support some kind of real economic activity which you care about, this is bad deleveraging. But balance sheets can be bolstered without cuts in activity too, as the diagram makes clear: with more equity a balance sheet of the same size has lower leverage. And the books can be made both larger and stronger at the same time, if equity grows proportionately more than debt. This would be good deleveraging. Whichever the type, good or bad, lower leverage should reduce risk: equity buffers are bigger and the likelihood of default is lower. The benefit should be lower borrowing costs. But a new tranche of data for British firms released today shows that this is not always the case. The problem is set out in three charts that use this, and other data, below. The first shows that, since mid 2008, firms have cut more debt than they have raised equity. Balance sheets are smaller and activity is lower, suggesting British firms are stuck in one of Richard Koo’s balance sheet recessions. Adding to the misery, firms’ newly beautified balance sheets have not led to cheaper borrowing. In fact (second chart) rates on new borrowing have been increasing, despite a fresh round of quantitative easing. The likely reason (third chart) is that banks’ own debt costs—as proxied by CDS premia—are on the rise again. That makes lending more expensive to do, and so banks—themselves trying to deleverage—pass the cost on to their customers. So British firms are experiencing ugly deleveraging: all the pain with none of the gain.

By Simon Johnson
At one level, the pursuit of higher and more robust capital requirements for banks is not going well. The US Treasury insisted, throughout the year-long financial reform debate, that capital should be the focus – increasing the loss-absorbing buffers that banks must carry – and that they (and other regulators) needed to negotiate this is through the Basel Committee process.

By Steve SlaterLONDON (Reuters) - When David Armitt needed to refinance loans last year for his 153-year-old manufacturing company in Yorkshire, he found British banks reluctant to lend. So he took the nuclear option.

Investment banks must take tough decisions to quit ailing business areas and should reduce their balance sheets by $1 trillion – or almost a tenth – to lift profitability, an industry report said.
European banks face a particularly challenging outlook and are likely to continue losing market share to big U.S. rivals, according to the 2014 Wholesale & Investment banking Outlook by Morgan Stanley and Oliver Wyman, released on Thursday.

Many of you will be familiar with the fact that past returns from notable stock indices, such as those in the US, are a biased indicator of the likely future returns to investing in equities. The problem is that due to war, government interference, and financial collapse, some stock markets disappeared altogether, wiping out investors. In some countries this has even happened multiple times.